Fine-tuning the portfolio for retirement

Alexandra Cain

Aug 30, 2019 — 11.00pm

Many – although not all – exchange-traded funds track a benchmark index and aim to replicate its performance. Proponents of the rival actively managed approach to investing claim investors give up returns when their investments merely follow an index.

But ETFs' supporters say few actively managed funds beat the benchmark. Additionally, index funds' fans say their low fees do not erode returns as much as more expensive active funds do. As a result, ETF investors say these instruments help support retirement savings.

"ETFs give individual investors the same opportunities that are available to institutional investors, and allow them to implement their preferred asset class exposure or investment approach through a simple and low-cost vehicle," says Thomas Reif, Asia Pacific global portfolio strategist for State Street Global Advisors.

Lower fees can add up to bigger returns for retirement. iStock

"Fees matter to investors who are focused on their retirement savings. Every dollar they save on fees is a dollar that they have in their retirement savings, and it is also a dollar they don't need to take risk to earn."

According to Reif, over 20 years, if an investment earns 5 per cent, a 0.5 per cent fee saving would add $242 for every $1000 invested, 15 per cent of the total investment return. "For round numbers, a 1 per cent saving on fees saves $462, or 27 per cent of the total investment return," he says.

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Alex Vynokur, chief executive officer of BetaShares, agrees a reduction in fees is one of the most meaningful impacts from using ETFs for a core holding of Australian equities in a portfolio.

"As an investor, fees are one of the few things that are in our control and, needless to say, every dollar saved in fees is another dollar that can be used in retirement," he says.

Diversified portfolio

Keeping costs low is all the more meaningful given active managers often do not beat their benchmarks. Recent research by S&P Dow Jones showed for the year to June 30, 2017, only 35 per cent of Australian active managers who have the S&P/ASX 200 as their benchmark beat it.

"Given these statistics, it stands to reason that using a low-cost ETF providing access to a diversified portfolio of Australian shares makes a lot of sense," says Vynokur.

Aside from fees, using a sector-specific or country-specific ETF can generate additional returns given individual sectors and countries will, from time to time, outperform the broad share market.

"Investors often use ETFs in a core and satellite approach – using a low-cost broad market exposure for the core of the portfolio and then using specific sector and country-specific satellites to take different views," says Vynokur.

"More importantly, adding sector or country exposures can improve diversification and help reduce risk in portfolios which may otherwise be heavily weighted to Australian shares."

"They provide flexibility and low cost, which is especially important in the long run, as basis points in saved fees can compound to substantial savings over the decades," says Schneider.

Many financial advisers support clients' use of ETFs in their portfolio as simple, low-cost investments.

"ETFs give investors a cheap and accessible method to access a large number of markets," says Michael Miller, a certified financial planner and principal of MLC Advice Canberra. "These markets can be very broad, for instance a core Australian equity index. They may also be very narrow, and focus on a particular sector, country or asset class, such as a precious metal."

This means that an investor can make specific allocations as part of their portfolio. "If they're getting this right more often than wrong it can improve returns, but it can just as much damage returns if the investor is getting calls wrong," he says.

Trading costs

Miller says although ETF fees are low, how an investor uses these instruments determines the trade-off between fees and returns.

"An investor who is using a long-term buy and hold strategy may get a significant benefit from the lower fees involved. But an investor who is trading in and out of different ETFs may achieve little benefit from the low holding costs if their trading outcomes are poor," he says.

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Investors also need to consider their trading costs with ETFs. Says Miller: "ETFs' management expenses can be low, but you will often need to pay brokerage costs for your investment. So a frequent trader might have low management fees but then be incurring high brokerage costs."

Investing in ETFs can also affect returns in other ways, says Reif. "They can result in a lower capital gains tax bill, as the turnover of the funds which support Australian ETFs are generally at the lower end of strategies in their asset class. This leads to a greater deferral of capital gains, so investors can earn income on their unpaid taxes. It is important to remember that these taxes are unpaid and not due, as they are unrealised. This can be considered a loan from the government, which investors implicitly use to improve return," he says.

Investors also benefit from franking credits. Indexed ETFs in Australian equities deliver investors the return of Australian equities and all franking credits for their holdings.

ETFs are likely to continue to be popular with investors chasing sensible returns and wanting low fees. As long as they watch brokerage costs, investors will hopefully continue to benefit from these simple and transparent investment vehicles.